US Is Addicted To Fiscal Crack

The US is addicted to federal deficits (fiscal crack). Despite low unemployment we continue to run large deficits.

What Research Tells Us

Research on the economic impact of fiscal deficits reveals a nuanced relationship between government borrowing and GDP growth.1 Most empirical studies find fiscal multipliers—the ratio of GDP change to deficit change—typically ranging from 0.4 to 1.0 in normal economic conditions, meaning each dollar of deficit spending increases GDP by 40 cents to one dollar.2 However, this headline figure masks important contextual variations that economists have identified.3

The effectiveness of deficit spending varies significantly depending on economic conditions.4 During recessions, particularly when interest rates are constrained at the zero lower bound, multipliers can increase dramatically to 1.5-2.0, as seen during the 2008 financial crisis and 2020 pandemic.5 Conversely, when economies are operating near capacity or when debt levels are already high (typically above 90-100% of GDP), multipliers diminish substantially and can even turn negative.6 Importantly, the composition of fiscal measures influences outcomes—targeted transfers to low-income households and infrastructure investments generally yield higher multipliers than tax cuts for higher-income groups.7

Looking At Deficits vs Unemployment Over Time

In the spirit of Keynes, I decided to look at how the budget deficit and unemployment behaved over recent history. Did the government use deficit spending to improve employment. Looking from 2004 to today one can see three distinct periods. (Charts below)

Global Financial Crisis

From 2004 to the Global Financial Crisis both unemployment and the deficit as a % of GDP were trending down. However while close to ‘full employment’ we were still running 4% deficits. The GFC saw a significant expansion of the deficit, followed by a retrenchment of deficit spending back to the 2004 share.

Pre-pandemic Deficit-led Expansion

From 2014 to 2019, the deficit share expanded despite improving unemployment conditions. This would seem to violate Keynes dictums.

Pandemic & Recovery

The pandemic saw a brief, extreme expansion of the fiscal deficit in response to a rapid jump in unemployment. This stimulus was mostly retracted by 2022.

Deficit Impact On Growth

I asked Claude3.7-Sonnet to create a graph with estimates of the impact of the fiscal deficits on GDP using the above referenced papers. The results do seem to align with other published research.

2025 & 2026

The 2025 deficit is expected to be between around 6.3%, likely higher than economists like Keynes would proscribe. The current estimate of the House ‘Big Beautiful Bill’ budget deficit is around 7%, so a marginal move in the wrong direction given the current state of the economy.

For 2025, using the same weights as above, the deficit was essentially a small drag on GDP (-0.1% to -0.2%). A 2026 deficit of 7% would be expected to add 0.7% to GDP. To be fair, this does not include any changes from increased tariff income, should it actually emerge.

Moving in 2026 to a “neutral” 3% deficit would have a GDP impact of -2.4% to -3.4% of GDP growth, likely causing a recession. Balancing the budget would have an impact of -4.5 to -6.4 percentage points of GDP growth, pretty much guaranteeing a deep recession. A 2026 deficit of approximately 3.8% of GDP would be consistent with 0% economic growth, assuming CBO's baseline 2026 deficit projection of ~6.0% of GDP and average fiscal multipliers of 0.7-1.0.

Remember, 2025 US GDP growth, per the Congressional Budget Office, is estimated at only 1.9%.

The definition of an addict is one who has a compulsive, chronic dependence on a behavior, despite harmful consequences to their health, relationships, or responsibilities.

Continuing Deficits & Term Premium

The TBAC is being explicit.

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. — John Maynard Keynes

Inflation Expectations Are (And Have Been) Unanchored.

I’ve highlighted in the past that the U-Michigan survey of consumer inflation expectations has soared. Meanwhile, the NY Fed’s survey has also increased, but not nearly to the same extent. There are methodological differences between the two (cross-sections vs panel; language inclusivity; digital vs analog; mean vs median statistic; wording of question)

Either way, neither looks ‘anchored’ to 2%.

Digging deeper, the Federal Reserve recently held its Second Thomas Laubach Research Conference. Laubach is the former Director of Monetary Affairs for the Federal Reserve Board and is highly respected.

At the conference, Yuriy Gorodnichenko, the Presidential Chair in Economics at UC Berkeley, gave a presentation (Youtube link) titled Inflation Expectations and Monetary Policy: What Have We Learned And To What End? It is based on this paper. Here are the slides. Here are his first two lessons:

One of his main points is the obvious, but frequently overlooked, point that there are multiple definitions of inflation expectations.

Much of the paper and presentation is for economists, and hence he talks about the tests economists use. But he also discusses “the eyeball test.”

And unanchored expectations are due to attention.

And his conclusion is that central bankers shouldn’t be too full of themselves.

Other Things We Probably Should Talk About

• Moody’s Cuts Deposit Ratings at Major Banks After Downgrading US (Bloomberg)

  “The downgrade of the US government’s rating indicates that it has less ability to support these highly-rated obligations,” Moody’s analysts wrote. Through Moody’s downgrades, it removed the “one notch” of US government support the ratings previously included.

• TIPs Premium Soars

  

• Long Term JGB (3.05%) and Bund (3.11%) Yields Rising, Converging

  • Japanese bond yields soar as investor demand falters

    

  • German 30-year bond yields hit two-month high; investors fret over long-term US debt